A conventional loan is a common mortgage type, but one that is not issued through government insured loans, like FHA, VA, or the USDA. They generally have higher credit requirements than government insured loans but are available for a wider range of properties.
Here’s everything you need to know to qualify for a conventional loan.
What Is a Conventional Loan?
Conventional loans are provided by banks, credit unions, mortgage companies, and other financial institutions. Although those institutions will initially fund the loan, it’s ultimately sold to one of the two government chartered mega-mortgage agencies, FNMA (“Fannie Mae”) or FHLMC (“Freddie Mac”). As such, the loans must meet the underwriting guidelines of the two agencies.
But perhaps what most differentiates conventional loans from government loans is private mortgage insurance (PMI). While mortgage insurance on government loans is provided by government agencies, like FHA and VA, conventional PMI is provided by private insurance companies.
PMI is required whenever you make a down payment of less than 20% of the purchase price. It also applies if you refinance with less than 20% equity in your home.
Since a smaller down payment (or equity investment) represents a bigger risk for lenders, PMI is required to reduce that risk. Though the borrower will pay the monthly premium on PMI, the policy insures the lender if the borrower defaults.
PMI will reimburse the lender for a percentage of the loan amount, but not the entire loan. It’s designed to reduce the lender’s exposure to less than 80% of the value of the property.
Conventional Loan Requirements
The mortgage underwriting criteria for all types of mortgages is very similar, but below are the specifics of conventional loan requirements:
- Eligible properties. Conventional loans are available for single-family homes, 2-to-4 unit homes, condominiums, planned unit developments (PUDs), and manufactured homes. While FHA and VA loans are available only for owner-occupied, primary residences, conventional loans can also be made on vacation homes and investment properties.
- Minimum credit score requirement. The standard minimum score requirement for conventional loans is 620. But your credit score plays an important role in determining the interest rate you’ll pay on the loan. A borrower with a credit score below 640 will pay a rate at least 1.5% higher than someone with a credit score at least 760.
- Employment. Lenders look for borrowers to have a minimum of two years of stable employment. Multiple jobs during that time frame are acceptable as long as income is stable or increasing. Periods of unemployment are also acceptable if the applicant has been satisfactorily re-employed.
- Debt-to-income ratio (DTI). DTI is your new house payment, plus other debt payments, divided by your stable monthly income. The standard maximum is 43%, but some lenders will go as high as 50% for a strong borrower profile. That may be evidenced by a very high credit score, a large down payment, or substantial assets after closing.
- Down payment. Conventional loans generally require a minimum down payment of 5%, though there are programs for first time and low-income borrowers with a down payment reduced to 3%. However, second homes and investment properties usually require higher down payments.
How Does a Conventional Mortgage Work?
To obtain a conventional loan, you’ll need to complete a multi-page application, then sign several disclosures and disclaimers. Most lenders will require you to pay an application fee that will be used to cover the cost of an appraisal and running your credit report.
You’ll also be expected to supply documentation that supports the financial claims in your application.
To support your income, be prepared to provide the name, address and phone number of your employer, as well as your most recent pay stub and W-2s for the past two years. Self-employed borrowers must be prepared to submit complete tax returns for the past two years.
You’ll also need to verify your down payment source. This is typically satisfied by providing copies of bank statements for the two most recent months before application. However, many lenders are able to verify this information directly with your bank.
If the loan is for a purchase, you’ll be required to supply a copy of the fully executed contract on the property, as well as evidence of the earnest money deposit submitted with the contract.
You may also need to provide a divorce decree if you either pay or receive alimony or child support.
What Are the Types of Conventional Loans?
Conventional loans come in two basic types:
Fixed-rate mortgages (FRMs)
These are loans with an interest rate and monthly payment that’s fixed for the life of the loan. It’s the most secure type of loan for homeowners, because it offers a predictable monthly payment.
Adjustable-rate mortgages (ARMs)
These are loans with fixed terms for the first three, five, seven, or 10 years. After the fixed-rate term, they convert to a one-year adjustable.
For example, a “5/1” may start out with an interest rate of 3.5% for the first five years. After that period, it will switch to a one-year adjustable loan. The interest rate adjustments are limited by what are known as “caps.” A typical cap arrangement will limit the rate increase to no more than 2% in the first year, and 5% over the life of the loan.
With those limits, the rate after the first adjustment (on a loan with an initial fixed rate of 3.5%) cannot exceed 5.5%, or 8.5% over the life of the loan.
ARM loans are riskier financing arrangements for homeowners. They’re generally recommended only if you plan to sell the home within the initial fixed-rate term.
Both fixed-rate and ARMs are available in terms ranging from 15 to 30 years. At the end of the loan term, the loan will be fully repaid.
Conventional vs. Conforming Loans
The terms “conventional” and “conforming” are often used interchangeably with conventional mortgages. But conforming refers only to those loans that fit within maximum funding amounts set by the federal government.
Maximum loan amounts for conventional mortgages are set by the Federal Housing Finance Agency (FHFA), and adjusted each year. For 2022, the maximum loan amount for a single-family property is $647,200.
This is the maximum in the vast majority of counties across the US. But it’s higher if an area is deemed to be “high cost.” In the most expensive counties, that maximum is $970,800. Even higher loan amounts are available for properties with between two and four living units.
There’s a second category of conventional mortgages, commonly referred to as jumbo mortgages. In most respects, these loans work the same as conforming conventional mortgages. The main difference is that they are available for higher loan amounts. Some loans can go into millions of dollars.
For example, if you want to purchase a single-family home for $1 million, with an $800,000 mortgage, you’ll need to use a jumbo mortgage to get the job done.
Unlike conforming conventional mortgages, jumbo mortgages are funded by banks and other financial institutions. But even though the underwriting criteria are similar to conforming conventional loans, including PMI requirements, each individual bank can have its own guidelines.
For example, jumbo mortgages usually have higher minimum down payment requirements. They may require 10%, 20% or more. You can also expect jumbo mortgages to have higher minimum credit score requirements. The lender may set the minimum at 680, or even higher.